The intrinsic value of a share is the basis of value investing, a measurement used to analyze the fair value before investing. This is completely related to the company’s business. There is a difference between the price of a share and the value of a share.
Every value investor calculates the intrinsic value before purchasing a stock. It is not an assumption value. It has to be calculated using business output figures.
The price of the stocks does not coordinate with the company’s business. It is completely new and market condition-based.
There are two types of stocks 1. Overvalued 2. Undervalued. Valuation has to be done. That’s why we should be strong in our fundamental analysis
Here, we will cover calculating intrinsic value using a few methods: the Graham method, the Buffet method, and calculating the average of EPS using financial assets on the balance sheet.
1. Graham’s Formula for Intrinsic Value of Share:
Graham used to calculate the intrinsic value of a share with the EPS (Earnings per share) by coordinating with the expected growth of the particular company, divided by the return of a 10Y – Government bond (Currently 7.75% in India)
V = [EPS x (8.5 + 2g) x 4.4 ] / Y
- V – Intrinsic Value of share
- EPS – Average of last 5 years EPS (this gives us conservative value)
- g – Estimated growth of the company
- Y – Interest rate of 10 – Y Government bond (7.75% RBI Savings Bond)
How to calculate g (Estimated growth of the company):
The company’s estimated growth can be calculated by understanding the last 5 years of EPS. Once we find out the 5 years EPS, then calculate 5 years EPS growth.
The 5 years EPS growth will be the estimated growth of the company (g)
Now, let us calculate the intrinsic value of ITC.
g – 9.13 (last 5 years EPS growth)
EPS – 9.7 (Avg of 5 years EPS)
Y – 7.5% (Government bond yield)
So, the Intrinsic Value of share will be, V5 Y AVG= 152.28.
In my previous topics, I mentioned that intrinsic value has an interval (value range). So we will calculate the range by 5 year average EPS and last year’s EPS. We have found the value of the 5-year average, now let us calculate the current EPS value
g – 10 (Growth on EPS from 2019 to 2020)
EPS – 12.45
Y – 7.5%
So, the Intrinsic Value will be. VCurrent= 208.16.
The intrinsic value of the share range will be between VCurrent to V5 Y AVG, i.e. 208.16 – 152.28
This is calculated using Graham’s Formula. We can also use a calculator at the link below. Graham’s Calculator
2. Buffet’s Way Of Calculating Intrinsic Value of Share:
Buffet’s method of calculation is similar to Graham’s method of calculation. The only difference here is the “Margin of Safety.”
What is the Margin of Safety?
The safety margin is considered a safety proportion of 10-30%, and we reserve the right to buy any stock with the intrinsic value. We calculate the margin of safety because we will not be assured of the company’s external cause, which leads the company to a decrease in EPS or profit. This is why we should calculate MOS.
Intrinsic Value = Graham’s Calculator – MOS
Let us take MOS as 10% for ITC. Other stocks that have high P/E can be considered up to 30%.
VCurrent = (208.16 – 10%) = 187.34
V5 Y AVG = (152.28 – 10%) = 137.05
So, the intrinsic value with a 10% margin of safety is at an interval of 187.34 to 137.05.
This means that when ITC is between 187.34 and 137.05, it will be an attractive price to buy. If it goes beyond 137.05, it will be very attractive.
Use the following link for the Intrinsic Value calculator.
3. Calculation Using EPS:
Unlike the formula used in Graham’s calculation, this calculation is simpler and easier to use to find the range of a stock to buy.
We have to take the average 5-year EPS of stock and calculate the stock price using the P/E method in the range of 12-16, which is attractive for buying the stock.
Let us calculate the value range for Infosys,
The 5 years average EPS = 36.7
So Price at P/E 12 = 440
And Price at P/E 16 = 587.2
So, the price value of Infosys, defined by attractive P/E value, will be 440-587.2
4. Calculation Using Income Statement And Balance Sheet:
This is a method to analyze the intrinsic value of a stock by liquidating cash in the company’s hand, the main aim of this calculation is to find out Excess cash per share and Earning Value of the stock.
Intrinsic Value = Earning value of the Stock + Excess Cash per share
Earning Value of the Share:
This will be calculated based on the income statement. From the income statement, we have to choose only the EPS. So, the Earning Value of the stock is considered to be EPS divided by the Expected return
Earning Value of the stock = EPS (TTM) / Expected return.
Let us calculate the same ITC for the expected returns of 7.5% and 10%. EPS of 2020 is 12.45
So, the Earning Value of the stock for ITC will be range of 124.5 to 166.50
Excess Cash Per Share:
This is calculated by the balance sheet. The calculation should be more conservative and only based on cash or profit flow, which is easily liquidating. In terms of liabilities, consider the complete liability component.
Let us move towards the ITC Balance sheet of 2020. Page 164.
There are two types of Assets: Non-Current Assets (Fixed Assets) and Current Assets.
In these two categories, we have to calculate only “Financial Assets.” In Financial Assets, exclude components like loans and trade receivables. These components are not cashed in hand.
So, regarding the balance sheet,
(A) Non-Current Asset (Fixed Asset) = Investments + Others
= 13455.5 + 607.09
= 14062.68 cr
(B) Current Assets = Investments + Cash& Cash Equivalent + Other bank balance
= 17175.02+561.84+6281.84
= 24018.7 cr
(C)Total Assets (A+B) = 38081.38
(D) Total Liabilities = Current liabilities + Fixed Liabilities
= 2116.79 + 9089.41
= 11206.2 Cr
(E) Earning Value of Company(C-D) = Total Assets – Total Liabilities
= 38081.7 – 11206.2
= 26875.38 Cr
(F) Total Number of Equity Shares = 1229.52 Cr
Earning Value of Company Per Share = E/F
= 21.85
So, we have calculated the earning value per share is 21.85.
Now, we will go back to calculate Intrinsic value,
Intrinsic value = Earning Value of a stock + Earning Value per share
= 166 + 21.85 = 187.85 (Upper Limit)
So, the intrinsic value of the ITC will be of range 187.85 – 146.65
From the above four types of calculations, we have found that the calculation using the Buffets method and calculation based on the balance sheet and income sheet seem similar in the range from 140 – 187 as the intrinsic value.
Conclusion:
· Intrinsic value of share is the most important before investing.
· The stock value is calculated by the company’s business, not by the price we trade.
· We can use all four methods to calculate the intrinsic value of a share. Choose the average of all four values.
· Between the intrinsic value ranges, we can buy a stock to become an intelligent investor.